Do Financing Constraints Lead to Incremental Tax Planning? Evidence from the Pension Protection Act of 2006
57 Pages Posted: 1 Aug 2018 Last revised: 26 Dec 2018
Date Written: December 2018, 2018
Whether financial constraints affect a firm’s investment levels is an unsettled issue that is central to financial economics. Recent studies examine whether internally generated cash flows via tax planning informs this debate, yet these studies seemingly provide mixed evidence. Additionally, these studies face identification challenges, may not generalize to all tax planning activities, and fail to quantify the extent to which tax planning activities mitigate investment shortfalls caused by financial constraints. To establish a clear causal relation between financial constraints and corporate tax planning, we use the Pension Protection Act of 2006 (PPA 2006) as an exogenous shock to financing constraints for pension firms, but not for other firms. Using a difference-in-difference design, we show that pension firms decrease their cash effective tax rates by about 3.3 percent after the PPA 2006, but other firms do not experience such a decrease. We also show that the incremental tax planning activities mitigate pension firms’ investment shortfall by about 14 percent. Overall, our paper reconciles seemingly mixed prior literature and sheds light on both the causality and economic magnitudes of corporate tax planning in response to financial constraints.
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